Portfolio drift and the importance of rebalancing

All your pension and savings money are placed into a portfolio of investment funds with an appropriate asset allocation.

Asset Allocation

An investment strategy which balances risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.

The 3 main asset classes – equities, fixed-income, and cash and cash equivalents – have different levels of risk and return, so each will behave differently over time.

Portfolio Drift

The natural tendency for an investment portfolio to become more heavily weighted in the assets which have performed well, and become under-weighted in the assets which have not performed so well.

The issue with drift is your portfolio no longer has the appropriate asset allocation agreed with you at the outset. This poses many risks covered below.

An Example of Drift

For the sake of simplicity, let’s assume a simple 50/50 asset allocation between Equity Funds and Government Bonds. You have £2,000 in total to invest. Of this you invest £1,000 in Equity Funds and £1,000 in Government Bonds.

Over the year, the stock market dropped significantly, losing 20% of its value. Your Equity fund is now worth £800. At the same time, your Bond Fund has increased 30% in value, making your bond fund worth £1,300. As a result, you no longer have a 50/50 allocation.

Only 32% of your portfolio is now invested in Equities and 68% is invested in Government Bonds. The original asset allocation was 50/50 Equities/Bonds. It is now 32/68 Equities/Bonds. This is Portfolio Drift.

In this case, where your allocation in Government bonds has risen significantly, you may not make the most of future growth opportunities offered by Equity funds.

However, were the situation reversed and you now had 68% in Equities and 32% in Government Bonds instead of the 50/50 you started with, you would be heavily exposed in the event of a downturn in share prices (which have a greater tendency to fall than Government Bonds

The Important of Portfolio Rebalancing

In order to re-adjust drift twice a year, in January and July, all our client portfolios are re-balanced back to their agreed asset allocation. Re-balancing means we sell the winners and buy the losers in order to bring your asset allocation back to its starting point.

An Example of Rebalancing

Going back to our example from the previous page, you currently have £800 in the Equities Fund and £1,300 in Government Bonds. Your portfolio has risen in value from £2,000 to £2,100, making a gain of £100.

By selling £250 of the Government Bonds and using that money to buy £250 of the Equity Fund, you end up with E1,050 in stocks and E1,050 in bonds. You have now re- balanced your portfolio back to your original 50/50 strategy and kept the gain.

Don’t fear selling winners & buying losers

You may think it’s counter-intuitive to have sold the Bonds which did so well, and buy Equities which just lost you 20%.

Firstly…

YOUR ORIGINAL STRATEGY WAS THE CORRECT STRATEGY FOR YOUR RISK TOLERANCE AND YOUR GOAL.

By allowing your portfolio to drift you are either taking on more risk than is necessary or you are lowering growth potential to a point where you may not achieve your goal over the long term.

Either of these could have dire consequences for your long-term investment returns and financial stability. All our investment strategies are for the long term — yours should be no different.Your strategy should not change year to year depending on what the winners and losers are.

Secondly, just because one asset class did well last year, doesn’t mean that class will do well this year. In fact, history has shown the best performing asset class is rarely the best performer the following year.

Being over-allocated in this year’s winners exposes you to more risk of those assets under-performing next year.

The opportunity in drift & rebalancing

When your portfolio drifts, it is because an asset or group of assets increased dramatically.

Investments don’t continue to go up forever, so as an asset class increases in value, the chances of a correction, or a drop in value, also increases. By selling off some of the appreciated asset, you are taking your gains and reducing the impact on your portfolio if the asset drops in the following year.

Additionally, drift can occur because another asset class dropped in value. In our example, the Equity fund dropped 20%. Though a sharp market downturn is scary, it is also one of the best times to buy more equities.

When an asset class has dropped in value, you have an opportunity to buy more units of that investment than you would have done when it was at its higher value. And you are buying it with the gains from another asset class which has gone up in value.

Think of Rebalancing as your opportunity to use this year’s gains to buy more potential future gains.

Interested in finding out more?

Seeking a second opinion on your financial future costs you nothing.

Simply call our friendly team on 0121 355 4455 or drop us an email to appointments@oaklandswealth.com to arrange a confidential chat.

Oaklands Wealth Management, founded by Helen Blackburn in 2004 advises

clients around the Midlands on retirement planning, pensions & investments.

Her firm holds British Standard BS 8577 for client service & investment process.

Minimum investment is £500,000 (£650,000 for pension transfers).